Markets: Down But Not Out
New York: February 02, 2009
By John R. Stephenson

With oil prices bouncing off the forty dollar a barrel level for several weeks now, it's hard to imagine that oil prices could be heading higher, but they will. Central banks around the globe are staring at economic data showing falling, rather than rising prices. Deflation and the bogeyman that America could become the Japan of the 1990s are keeping U.S. Federal Reserve Chairman Ben Bernanke up late at night. But Ben's helicopter is just warming up with President Obama about to airlift a massive $825 billion economic stimulus program to the moribund American consumer and business community in the hopes of jump-starting the economy.

To pay for this huge governmental spending spree, the U.S. has fired up the printing presses. The U.S. money supply (M2) over the last three months has been growing at a clip of 20 percent with no end in sight. The theory seems to be that if the bank prints it, someone will spend it. U.S. Treasuries are increasingly being lapped up by foreign central banks, which now own more than 50 percent of America 's debt. While these treasuries will undoubtedly mature at par, who's to say that the U.S. dollar won't depreciate 40 percent against the yuan or Euro like it did against the yen between 1971 and 1981?

It may seem incredulous to imagine a world where inflation is running wild, but that's exactly what we could be witnessing in the not-too-distant future. In the early 1950s, when the U.S. printing presses were fired up to monetize the debts from fighting the Korean War, inflation moved from being slightly negative to over nine percent within a nine month time frame. The same was true after World War II when inflation in the U.S. peaked at 20 percent in 1947 when the massive war debts were also monetized using that marvel of modern central banking — the printing press.

Demand for oil has been plummeting lately, as demand has fallen more than four percent in the U.S. , the largest customer for liquid gold on the planet. With tumbling U.S. demand, the once insatiable appetite of China and India has suddenly waned. The only thing that is falling faster than oil demand is supply with a long list of cancelled projects. The rhetoric out of Moscow and Caracas has all of a sudden dried up. In a bizarre turn of events, Venezuelan strongman Hugo Chavez, who just a year ago expropriated assets from ConocoPhillips and Exxon, is trying to woo western firms back in a desperate bid to develop Venezuela's Orinoco tar belt.

In Canada 's oil sands, announced project cancellations and delays have already affected over 1 million barrels per day of planned capacity additions. By 2010, oil sands production was supposed to increase by 400,000 barrels a day — with the announced cutback capacity, additions will be less than one-third of that amount. This is hardly an impressive growth rate from a region of the world that the International Energy Agency (IEA) expects to be the largest single source of new crude oil supply over the next two decades — almost three times more important than Saudi Arabia .

In basin after basin, the story is much the same; cancelled projects and slumping production. Mexican output is continuing to tumble as the massive Cantarell field continues to decline and replacements are nowhere to be found. Brazil 's conventional oil reserves fell in 2008 and recent discoveries such as the Tupi and Carioca fields in ultra-deepwater Brazil will cost more than $1 trillion to develop. When you add up all the cancelled projects, instead of growing oil production by 2 million barrels a day in 2010 as originally forecast, global supply will be down 1 million barrels a day.

But that's the good news, since the vast majority of announced cancellations have been on fields whose initial flow dates fell beyond 2010. If oil prices stay flat at the current levels, supply, rather than reaching a plateau of 88 million barrels a day in 2012 as originally forecast, could continue falling, reaching 76 million barrels per day in 2015. Once the global economy begins to grow, cheap supply will be nowhere to be found.

Unlike the 1970s and 1980s when oil prices spiked and then retreated, there is no ready source of $10 a barrel crude oil to meet resurgent demand. The International Monetary Fund estimates that the average breakeven cost for oil exporting countries that would cover their costs of production and balance the host government's books is US$57 per barrel.

Even a small increase in demand, say around the three to four percent range, would see us facing much tighter supply and higher crude oil prices. In 2007, when oil rallied from $60 to $100 per barrel, demand exceeded supply by about 1.5 million barrels. A snapback in the three percent range could see demand exceeding supply by 2 million barrels a day and oil prices could move sharply higher in a hurry.

Oil prices are likely to move sideways for most of this year, but starting in 2010, prices will begin to move higher. For my money, now is the time to start slowly positioning your portfolio by buying the larger capitalization senior oil & gas producers that have the greatest torque to rising oil prices.

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